Attention index investors: Practise what you preach

Index investors are a passionate bunch because they love the rewards offered by their diversified and low-cost approach to investing.

Who can blame them? The market is awash in high-fee products and shifty salespeople masquerading as advisers. Once you figure out their game, it's only natural to run the other way.

Problem is, even the most strident index investors I know have a tendency to say one thing and to do another. None of them strictly follow what I would call a pure approach to passive investing. Instead, they tend to slip back into some old habits.

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For instance, a few hold stocks they like in addition to their index funds. Others hang on to actively managed funds with large amounts of unrealized capital gains in an effort to delay a big tax bill. These are relatively minor indexing sins provided they're kept to a minimum.

On the other hand, many popular Canadian index portfolios take wild bets that put some active investors to shame. To see why, it's important to go back to basics.

Indexers want to get broad diversification at a very low cost because they believe picking individual stocks is a pointless waste of time and money.

To a true indexer, the optimum strategy would consist of buying a market-capitalization weighted index of the world's stocks in a cost effective manner.

Funds that track global stock indexes have only recently become a reality for most investors. These days the Vanguard Total World Stock ETF is one fund that fits the bill nicely. It tracks world stocks at a modest annual fee of only 0.19 per cent.

It's easy to invest in the Vanguard ETF or replicate it with other low-fee funds. Problem is, most Canadian indexers do neither.

Instead they cobble together an unsightly mess of index funds that suits their fancy. But in doing so they deviate sharply from the idea of buying the whole market and wind up making big bets on small parts of it.

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For instance, one popular index portfolio puts 40 per cent of its assets into bonds, 20 per cent into Canadian stocks, 20 per cent into U.S. stocks and 20 per cent into international stocks. If you just focus on the equity part of the portfolio, it doesn't look like the global stock market.

The Canadian stock market is actually quite small when stacked up against all its foreign counterparts. It represents only 4 per cent of the world market based on market capitalization. On the other hand, the U.S. represents 48 per cent and the rest of the world accounts for another 48 per cent.

Putting an equal amount of money into Canadian, U.S. and international stocks is the equivalent of making a big bet on 4 per cent of the world's stocks and against the other 96 per cent of the market. Investors who take this approach aren't following the market at all.

The results show it. The equal Canada, U.S. and international portfolio, using low-fee ETFs, underperformed the Vanguard Total World Stock ETF by more than two percentage points in 2012. It lagged by nearly as much in the first nine months of this year. Both represent huge deviations from market performance.

Of course, some years the big bet pays off. That's to be expected when you play indexing roulette instead of following the market.

If you truly believe in the philosophy behind indexing, don't fall prey to fancy geographical mixes and home country bias. Stick with the program and buy the global market at a low cost.